Today’s post continues Part 1 with a further explanation of this rapidly-growing alternative to the mutual fund. In my initial post I explained that ETFs

are created by financial institutions in large blocks that can be freely converted into underlying securities

are transparent, meaning that the underlying securities are publicly disclosed on a continuous basis

trade continuously on financial exchanges at prices that generally move closely with the underlying securities

are generally liquid, reflecting the liquidity of the underlying securities

are usually (but not necessarily) linked to a securities index

tend to have low management costs

These are generalizations, and may not be true for a specific ETF. This caveat also applies to the remaining characteristics, taxation efficiency and the tendency of ETF prices to track the underlying securities indices closely.

Taxation Efficiency
When properly managed, an exchange traded fund should produce lower capital gains distributions than a typical open-end mutual fund. This efficiency arises from the interchangeability of ETF shares with stock shares.

When a mutual fund sells stock shares (e.g., to pay for redemptions or just to close out or reduce a particular stockholding), it realizes a capital gain. If it has not sold other shares that produce an offsetting realized capital loss, the mutual fund is required by law to distribute its capital gains to the fund shareholders. This is typically done in December and is a taxable event for fund shareholders. This means that even though shareholders have not sold any of their mutual fund shares, they have a tax liability for the year for that mutual fund.

In contrast to mutual fund shares, ETF shares are not sold when they are liquidated, they are exchanged for their underlying securities (a non-taxable transaction). If an ETF needs to liquidate some of its shares through such an exchange, its management can choose to exchange underlying security shares that have the lowest possible cost basis. If it were selling the securities outright, it would experience a capital gain, but because it is making a tax-free exchange, the low-basis shares are removed from its holdings without causing a taxable gain for the ETF shareholders.

Since an ETF usually reflects an index, its holdings only change when the index changes; when the index does change, the ETF must sell its shares and may generate a capital gain distribution as a result, although there are ways to minimize the impact of such events. Broadly speaking, ETFs tend to be more tax efficient than comparable mutual funds, although this is not always the case.

ETF Prices and the Arbitrage Effect
The liquidity, transparency, and passive nature of most ETFs mean that usually the purchase price of an ETF share will closely track the cost of the underlying securities of the ETF. That is, unlike a closed-end mutual fund, an ETF should not trade at much of a premium or discount. Why is this?

Consider what would happen if the market price of an ETF were to rise above the value of its underlying index. For the sake of this example, let’s say that an ETF share trades at $50 while the underlying stocks are worth $49. Since the ETF shares and the underlying stock shares can be freely converted into each other (and since everyone knows which stock shares are contained in ETF because of transparency), an institutional investor could instantly discover that the ETF is overpriced relative to the underlying stocks. The institution could buy underlying stocks for $49, immediately exchange them for an equivalent number of ETF shares, sell the ETF shares at $50 each, and make a guaranteed profit. In the process of making these trades, the transactions would tend to make the stock prices go up and the ETF market price go down. This process would continue until the difference between the ETF share price and the underlying stock price was essentially zero.

If, on the other hand, the ETF’s shares began trading at a discount to the underlying securities, an institutional trader could carry out the opposite transactions for a guaranteed profit; as long as the profit motive and trading mechanism exists, the transactions would cause the prices of the stocks and ETF again to converge. This process, called arbitrage, can take place whenever there are two liquid, equivalent, and interchangeable assets whose prices have diverged for some reason. Although arbitrage mechanisms can break down in some situations, in practice, arbitrage causes most ETFs to track the cost of the securities in their underlying indices quite closely.

The reason that closed-end mutual funds can often trade for extended periods at premiums or discounts is that there is no interchangeability mechanism for a closed-end share. Therefore, a closed- end fund price abnormality can persist for a long time simply because investors have driven the market price excessively high or low for some reason.

Using ETFs Effectively
Overall, the primary virtues of an ETF over a comparable mutual funds are low expenses and high tax efficiency. ETFs can be an attractive way for long-term investors to hold certain asset classes for these reasons. Although the ability to trade ETF shares throughout the day is not useful for long-term investors, the transparency and liquidity of ETFs usually ensure that they are always reliably priced close to the value of the underlying securities, so that whenever they are sold, the likelihood of a price abnormality is low.

The explosion of ETF options means that there are now ETFs that provide access to a wide variety of asset classes, including currencies and commodities. There are ETFs linked to a large number of specific stock sectors, countries, and regions, including some exotic foreign markets in which it would be difficult to invest otherwise. This makes ETFs potentially useful for investors who need an easy way to purchase a diversified basket of securities in a particular asset class or category. Because ETFs can be shorted or purchased through options, they can be used in all sorts of complex investment strategies. There are even some ETFs that behave like financial derivatives: some of them go up (or down) in value twice as fast as their linked index, while others are “short” ETFs that move in the opposite direction from their index.

Like any other financial product, ETFs are useful for the right purposes, but they are not right for every need. There are also a number of ETFs that lack one or more of the characteristics that are normally thought of as ETF advantages. Prudent investors will do well to make sure they understand what they are buying, rather than assuming that every ETF possesses the typical ETF characteristics.

It seems to me that exchange traded funds are becoming faddish in the sense that new ones are being introduced daily (or at least, it feels that they are) and many seem designed to capture the money of investors interested in the latest “hot” investment idea. Since there is such wide variety in ETF offerings, the ones that happen to be invested in assets that do well in the short-term may grow quickly by attracting the interest of unsophisticated investors who are chasing performance. Caveat emptor.